Understanding Deferred Tax: Bridging Temporary Differences in Financial Reporting

Deferred tax is often viewed as a complex and esoteric concept, misunderstood by many professionals and businesses alike. Contrary to popular belief, deferred tax is not an actual tax payment but an accrual for tax. It functions similarly to other accruals or provisions by aligning the tax effect of transactions with the period in which they occur. This alignment adheres to the accrual principle, ensuring that expenses and income are recognized in the appropriate periods. In this article, we will unpack the intricacies of deferred tax, providing clarity on its purpose and application.

What is Deferred Tax?

Deferred tax arises from the temporary differences between the carrying amount of an asset or liability and its tax base. According to International Accounting Standard 12 (IAS 12) – Income Taxes, deferred tax represents the income tax payable or recoverable in future periods in respect of:

1. Temporary differences
2. Unused tax losses
3. Unused tax credits

The calculation of deferred tax involves:

• Temporary Difference: The difference between the carrying amount of an asset or liability and its tax base.
• Income Tax Rate: Applied to the temporary difference to calculate the deferred tax asset or liability.

Taxable and Deductible Temporary Differences

Temporary differences can be broadly categorized into two types:

Taxable Temporary Differences

When the carrying amount of an asset exceeds its tax base, a deferred tax liability (DTL) arises. This signifies future taxable amounts that will increase taxable income when the asset is recovered.

Deductible Temporary Differences

When the carrying amount of an asset is less than its tax base, a deferred tax asset (DTA) arises. This signifies future tax-deductible amounts that will reduce taxable income when the asset is recovered.

This concept applies equally to liabilities, which can be viewed as items with negative carrying amounts. For example, a warranty provision of $500,000 has a carrying amount of -$500,000 and could result in future tax deductions.

Practical Example: Interest Revenue Accrual

Consider a scenario where a company lends $100,000 to its subsidiary on January 1, 20X2, at an interest rate of 3%, with repayment due on January 1, 20X3. The company recognizes interest revenue of $3,000 in 20X2 but pays taxes on this revenue only in 20X3 when the cash is received.

Journal Entries

1. In 20X2: Recognizing interest accrual revenue
   • Debit: Deferred interest revenue: $3,000
   • Credit: P/L – Interest revenue: $-3,000
2. In 20X3: Recognizing tax effects
   • Debit: P/L Current income tax (20% of $3,000): $600
   • Credit: Bank account or current income tax liability: $-600

Deferred Tax Liability in 20X2

To align the tax effect with the period of the transaction, a deferred tax liability (DTL) of $600 is recognized in 20X2:

• Debit: P/L – Deferred tax expense: $600
• Credit: Deferred tax liability: $-600

Reversal of DTL in 20X3

When the tax is paid, the DTL is reversed:

• Debit: Deferred tax liability: $600
• Credit: P/L – Deferred tax income: $-600

This ensures the tax effect aligns with the interest revenue recognized in 20X2.

Determining the Tax Base

The tax base of an asset or liability is the amount attributable to it for tax purposes. This calculation is fundamental to identifying deferred tax.

Tax Base of Assets

The tax base of an asset is the amount deductible against future taxable benefits. For example:

• Capitalized Software Development:
  • Cost: $30,000
  • Tax deduction when paid: $30,000
  • Remaining deductible amount: $0 (Tax base = $0)
• Depreciated Car:
  • Cost: $20,000
  • Tax deductions (25% annually for two years): $10,000
  • Remaining deductible amount: $10,000 (Tax base = $10,000)

Tax Base of Liabilities

The tax base of a liability is its carrying amount minus the amount deductible for tax purposes in the future. For example:

• Provision for Warranty Repairs:
  • Carrying amount: -$500,000
  • Deductible amount in the future: -$500,000
  • Tax base: $0

Conclusion

Deferred tax plays a pivotal role in financial reporting, ensuring that the tax effects of transactions are aligned with the periods in which they occur. By understanding the principles outlined in IAS 12, businesses can improve the accuracy and relevance of their financial statements. Recognizing deferred tax as an accrual rather than a tax payment demystifies its purpose and fosters better financial management.

At Dawgen Global, we specialize in navigating complex accounting standards like IAS 12. Let’s have a conversation about how we can assist you in making smarter and more effective financial decisions.

Next Step!